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Written by: Daryl Clements, Terrance Hults and Matthew Norton
From sticky inflation to rising rates to taxes, muni investors will face challenges in the year ahead. But there’s no cause for alarm. A flexible, active investment approach can help muni investors meet safety and income goals while adding some stability to their broader asset allocation.
Mixed Conditions Ahead
Inflation ranks near the top of any list of investor concerns today. Lately, consumer prices have been rising at the fastest pace since the early 1990s. What’s more, the problem is proving stickier than initially expected. What first appeared to be a short, COVID-19-induced visit has turned into an extended stay, thanks to robust consumer demand and a snarled global supply chain.
To combat stubborn inflation, the Federal Reserve has turned increasingly hawkish, accelerating its tapering of QE bond purchases in advance of rate hikes. We now expect the central bank to begin tightening monetary policy in March and to continue through 2023.
We think muni investors should be aware of but not overly concerned about rate hikes, for three reasons. First, higher yields translate into more income, which over time overcomes any initial hit to price. Second, thanks to their tax exemption, muni yields are less volatile than Treasury yields and tend to rise much less. In fact, historically, when Treasury yields rose by more than 50 basis points (b.p.), muni yields rose on average about half as much as Treasury yields. And third, when the Fed tightens, yields on intermediate and long bonds tend to rise less than yields on the shortest maturities.
For these reasons, in a Fed-tightening environment, investors should still be able to withstand a significant yield increase before realizing a negative return. For example, US Treasury yields would need to rise more than 150 b.p. over two years for a six-year muni bond to have a negative return. Meanwhile, the investor continues to benefit from bonds’ overall stability and higher income potential going forward.
Municipal bonds also still enjoy sound fundamentals and a favorable supply and demand dynamic. Current demand for municipal bonds heavily outweighs supply, which should fuel brisk activity—and price support—through 2022. The $1.2 trillion infrastructure bill or Build Back Better proposal aren’t likely to change things either. Any bonds issued through these measures are uncertain in the foreseeable future and would likely be quickly absorbed by the market, preserving the tight supply and demand dynamic and supporting municipal prices.
Overall, this is a challenging environment, but active managers with flexible investment mandates have ways to maximize performance and ensure that muni bonds continue to serve an important role in an investor’s asset allocation strategy.
1. Shorten your portfolio duration target—modestly. As a rule, a portfolio with a shorter average duration will be less sensitive to rising interest rates than a portfolio with a longer duration. Just don’t shorten too much, or you’ll lose out on income and get squeezed by inflation.
2. Lift a barbell. There’s no single path to achieving your portfolio’s duration target. A ladder may make sense in some environments, while concentrating in a narrow range of maturities or “barbelling” holdings of short and long bonds may make sense in others. In today’s yield-curve environment, a barbell structure will likely lead to better outcomes for investors.
3. Consider municipal credit. Mid-grade and high-yield munis offer more income, and they tend to be less sensitive to rate increases. In fact, historically, municipal credit has outperformed when rates rise. And credit risk isn’t a prevailing concern today, given the health of municipal finances.
4. Explore opportunities outside the muni market. When munis get pricey relative to taxable bonds, the most flexible managers can invest part of the portfolio in treasuries or investment-grade corporates to maximize after-tax income and return. Later, as muni valuations become more compelling, they can sell the taxable bonds at a gain and reinvest in munis at higher yields.
5. Choose an effective inflation-protection strategy. Muni investors should guard against surging inflation—realized or expected. Treasury Inflation-Protected Securities (TIPS), as well as inflation-linked municipals and Consumer Price Index (CPI) swaps, can help investors explicitly mitigate inflation risk while remaining tax efficient. Moreover, adding credit or shortening duration—but not too much—can provide more implicit inflation protection.
6. Harvest your losses for bigger benefits. Even underperforming muni bonds can spell opportunity. With tax-loss harvesting, active investors can deliberately sell at a loss to offset taxes on gains elsewhere in the portfolio. Besides lowering the tax bill, it can also boost performance, as the savings can be reinvested in the market at higher yields.
7. Leverage technology. Speed and accuracy are everything, and managers should turn to cutting-edge technology to process data and maximize pricing inefficiencies in the increasingly fragmented muni market. AB’s AbbieOptimizer continually scours tens of thousands of beneficial tax-loss scenarios, as well as other important and often untapped sources of alpha such as trading alpha and speed alpha—substantially raising the bar on muni investing.
8. Invest for impact. Responsible investing is becoming a more prominent and permanent theme across the market. So muni investors should also be sure to incorporate ESG factors in their analysis. And those looking to make a difference in their communities should consider impact investing, which seeks to make a direct—and measurable—social or environmental impact while generating a financial return. Impact investing and municipal bond investing are a natural fit.
From duration flexibility to new technology, the muni market offers many effective tools to play defense and pursue opportunities in 2022. The key for investors is to avoid the sidelines and stay active to use the tools to full advantage.